Mirage or arbitrage?

Last April, June and August,
ANZ Banking Group
,
National Australia Bank
and
Westpac
listed $4.5 billion of bona fide A- rated bonds on the Australian Securities Exchange with an expected “call" (or maturity) date in mid to late 2017. (The maximum terms can technically run another five years.)

A few months later, in November and December, NAB and ANZ sourced a further $1.7 billion by issuing two legally identical bonds with slightly longer maturities given the subsequent launch date.

The only big difference between these bonds, which should theoretically price closely, is where they are traded.

While the April, June and August bonds were targeted at mainly personal investors and listed on the ASX, the November and December issues are unlisted and were sold to institutional investors.

Specifically, the two unlisted or “wholesale" bonds are exchanged (or “settled") through a platform called Austraclear¸ which is where most investment-grade wholesale bonds trade. Austraclear is wholly owned by the ASX.

A final twist is that the ANZ and Westpac bonds listed on the ASX can be bought and sold two ways. The standard route is via the ASX’s CHESS system as any other share would trade.

Yet ANZ and Westpac also permit investors to settle bonds through an institutional platform called Euroclear, which is the largest central securities depository in the world. Trading via Euroclear has the benefits of lower costs (there is no brokerage) and larger volumes.

None of these bonds are “hybrids". They don’t have any “loss-absorbing" features that result in you getting converted into equity when things get bad. They are mainstay investments of the fixed-income market.

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By December and January, the listed and unlisted bonds were pricing as expected – at about 1.8 percentage points over the bank bill rate (producing a total yield of approximately 5 per cent).

It is worthwhile clarifying that all these bonds, and most hybrids, are “floating-rate". The income they pay moves up and down with the Reserve Bank’s cash rate – so they are distinct from “fixed-rate" bonds that do well when rates fall but suffer capital losses when they rise. High-quality floating-rate bonds with maturities less than 12 months are generally classified as “cash".

And when people talk about the price of floating-rate bonds, they typically refer to the margin they pay above the benchmark bank bill rate. Bank bills ordinarily price a little above the RBA cash rate. A floating-rate bond might offer, say, 2 percentage points above bills.

In late January, an external event broke down the pricing relationships between the listed and unlisted bonds. Westpac and NAB were about to launch more than $2.5 billion worth of ASX-listed unsecured, perpetual convertible preference shares. These “hybrids" proposed to pay a superficially attractive 3.2 percentage points over bills, much more than the 1.8 percentage points on the bonds. This is roughly the difference between a 5 per cent and 6 per cent return, all things being equal.

The bonds and hybrids are not actually comparable due to their distinct risks. It is like contrasting the interest rate on a bank deposit with the dividend yield on a stock.

The interest and principal owed under the bonds are unalloyed bank liabilities which must be repaid on fixed dates. They do not convert into equity, and rank ahead of hybrids and shares. In comparison, Westpac and NAB’s “hybrids" have no maturity – they are “perpetual" – and the “interest rate" they pay is not a liability but akin to a dividend the bank can choose not to pay.

Most striking is that the hybrids convert into pure equity (or potentially nothing) if “bad" scenarios materialise, such as if the bank’s capital buffer falls below a certain level or the regulator thinks conversion of the hybrids would keep the bank solvent.

Retail investors have been steered to the higher yielding hybrids, with one casualty being demand for the safer ASX bonds. Whereas in December and January the otherwise identical listed and unlisted bonds were all trading around 1.7 percentage points above bank bills, the ASX bonds blew out to 2.2 to 2.3 percentage points over bills (or up to 0.6 percentage points higher than the wholesale bonds).

This is especially interesting given the ASX bonds have shorter maturities than their wholesale equivalents as they were issued earlier. This would normally imply that they would trade at a slightly thinner margin over bills.

There is also an argument the wholesale bonds should demand a “liquidity premium" because investors can trade in larger chunks than volumes available on the ASX.

The contrary case is that the ASX bonds are more actively traded, albeit in smaller sizes, much more divisible (the minimum transaction on Austraclear is $500,000)and more plentiful.

Michael Saba, head of fixed income at Evans and Partners, helped prepare the chart, which compares the three ASX bonds with a measure of the wholesale bond prices. You can see the disconnect emerge in late January.

“Until a month ago, the unlisted and listed bonds, which are economically indistinguishable, were trading in a tight pack," Saba says. “Yet the new Westpac and NAB preference shares saw spreads on the ASX bonds blow out by 50 basis points as investors went on the hunt for pure yield."

So can you arbitrage between the two markets? It is not easy in practice. The big banks do “make markets" in the ASX bonds through Euroclear. But they generally price them off their ASX levels rather than the unlisted values. Any arbitrage would have to be based on analysis that suggested the listed and unlisted markets should converge back in price once the new hybrid supply is mopped up.

There is evidence of this. “The ASX selling is drying up," Saba says. “With credit markets steady, the listed bonds should rally as they have the most visible comparables in the wholesale market, which are trading much tighter."